Key tax challenges and opportunities facing China outbound investors

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With increased in Chinese investment to all parts of the world, KPMG China’s John Gu, partner, Michael Wong, partner, Alan O’Connor, director, and Karen Lin, director, take a look at the tax challenges for businesses and best practices to ensure Chinese investors’ offshore structures are efficient.

Chinese outbound investment had another record year in 2016,
with announced deals by Chinese outbound investors increasing
118.7% to $206.6 billion compared to 2015's previous high of
$94.4 billion. This stellar growth could see near-term
moderation in the face of recent changes, such as stricter
regulatory scrutiny of certain transactions and a tightening of
controls on foreign exchange purchases and cross border
payments. However, these regulatory changes are not viewed as
entailing a shift in China's national 'going-out' strategy and
are not expected to stop China actively engaging in outbound
investment. With growth continuing in Chinese investment to all
parts of the world, we take a closer look at the key tax
considerations, and in particular, the tax issues, for Chinese
investors when structuring their overseas investments.

Tax can have a significant impact on the after-tax profits
that Chinese investors derive from investing overseas. Managing
the total tax cost on overseas investments, therefore, needs to
be a key consideration for Chinese investors to help maximise
their after-tax return from such investments.

Impact that tax can have on investment returns

Chinese tax resident companies are subject to worldwide
taxation at a standard People's Republic of China's (PRC)
corporate income tax rate of 25%. This rate is generally lower
than the effective corporate income tax cost for most of the
countries that ranked among the top destinations for Chinese
outbound direct investment (ODI) in 2016, particularly when the
effect of withholding taxes is taken into account –
see Figure 1.

Therefore, one common focal point for outbound Chinese
investors is managing the level of withholding taxes imposed on
the repatriation of overseas investment earnings (seen in blue
on Figure 1), either through China's double tax treaties (where
a direct investment has been made from China) or under the
treaties of the jurisdiction of an offshore intermediate
holding company, where it is commercially justifiable to do so.
The ability of Chinese investors to establish and maintain the
necessary commercial substance for such structures to be
effective may become more challenging, as China and source
countries continue to strengthen their treaty anti-abuse
mechanisms in line with the OECD's BEPS Action 6 measures.

However, it is also important for Chinese investors to
minimise instances of possible double taxation in China on the
earnings of the overseas investment. There are three key
features of the Chinese international tax system that are
relevant for Chinese outbound investors in this regard
– tax residence, taxation of foreign sourced income
and controlled foreign company rules. We will look at each of
these areas in more detail and the challenges that they
present.

Tax residency of offshore entities

Under PRC tax law, an entity that is established outside of
the PRC can be subject to PRC corporate income tax on its
worldwide income if its "place of effective management" is
located in the PRC. Chinese authorities adopt a "substance over
form" approach when assessing whether an entity's "place of
effective management" is located in the PRC.

Chinese companies must therefore be mindful to implement
protocols to ensure their foreign subsidiaries do not have
their place of effective management in China and inadvertently
become tax resident in China. Some of the business protocols
which could be considered include:

Senior management responsible for daily
production, operation and management of the enterprise should
not perform their duties mainly in the PRC;

Strategic, financial and human resources
decisions should not be made or approved in the PRC;

Major properties, accounting records,
company stamps, board/shareholders' meeting minutes, etc.
should not be kept in the PRC;

The majority of directors (or equivalent)
with voting rights or senior management should not habitually
reside in the PRC.

These protocols are important because a change in residence
of the foreign subsidiary could have a number of negative
implications, such as triggering exit taxes under the tax laws
of the overseas country, the foreign subsidiary's profits
becoming subject to PRC corporate tax at 25%, and/or the
foreign subsidiary no longer being able to access double
taxation agreements (DTAs) in its country of incorporation.

However, there may also be certain situations where it is
beneficial for a non-PRC company to apply to be deemed a
PRC-resident company, which is possible under Guoshuifa (2009)
No. 82 or Notice 82. One such situation could be under a PRC
'sandwich' structure as shown in Figure 2.

Figure 2: PRC "sandwich" for PRC
FTC purposes

A PRC 'sandwich' arises where one Chinese operating company
(PRC Sub) is held by another Chinese parent company (PRC
Parent) through one or more overseas subsidiaries. The profits
of the PRC Sub will be fully subject to tax again when they are
received by the PRC Parent 'via' the offshore company(s)
because the Chinese tax paid by the PRC Sub is not a foreign
tax for tax credit purposes. Making the non-Chinese
intermediate holding company(s) tax resident in the PRC can
help to avoid double PRC taxation on the PRC Sub's earnings
when they are repatriated back to the PRC Parent, because
dividends paid from one Chinese resident company to another are
tax exempt.

A second situation might be where, for non-tax reasons, a
Chinese investor has incorporated an offshore company to make
its overseas investments. We see Hong Kong commonly used in
this way as it helps the Chinese investor to recycle funds from
the initial investment for use in other offshore acquisitions
and to facilitate future listings. As the funds are outside of
China, they will not be subject to PRC foreign exchange and
investment approvals. Deeming the foreign holding company as a
PRC tax resident may be a way to avoid an offshore company
adding an additional tier to the corporate structure for the
purposes of claiming foreign tax credits (discussed in more
detail below), and should not adversely impact the offshore
company's ability to claim benefits under China's double tax
treaties.

PRC foreign tax credits

The second key area is China's system for relieving double
tax on foreign sourced income. Although many capital exporting
countries use the exemption method for taxation of foreign
sourced dividends and capital gains, China still operates a
credit system. This can lead to potential double taxation if
the Chinese investor is unable to claim a credit for foreign
taxes paid on foreign sourced earnings.

Dividends received by a PRC entity from its overseas
investments are generally subject to PRC corporate tax at 25%.
However, a PRC entity will be entitled to credit the foreign
taxes paid, which are attributable to such dividends (e.g.,
withholding tax on the dividend and income taxes paid on the
underlying profits of the foreign entity paying the dividend),
provided certain conditions are satisfied.

It is important to ensure that foreign tax credits can be
claimed when profits are repatriated to the PRC to avoid
potential double taxation on such profits. For example, profits
derived from a PRC entity's Australian subsidiary would be
subject to 30% Australian income tax but no additional PRC
income tax would be incurred where a foreign tax credit can be
claimed i.e., the profits would be effectively taxed at 30%.
Whereas, if no foreign tax credit were allowed, the profits
would be subject to tax in both Australia and the PRC,
effectively taxing them at 47.5%.

One of the key constraints for claiming foreign tax credits
is the limitation on the number of 'layers' of foreign
subsidiaries, with an indirect credit only able to be claimed
down to the third tier of foreign subsidiaries (certain groups
of specified enterprises are able to claim indirect credits up
to five tiers). This limitation means that Chinese investors
need to pay close attention to both the legal structure of
overseas companies, which they are looking to acquire, and the
benefits vs costs of using an offshore investment platform to
acquire such targets. Where an offshore holding structure
pushes the tax-paying operating companies of the foreign target
beneath the third tier of offshore subsidiaries, the benefits
from accessing a more favourable tax treaty will need to be
balanced with the potential additional tax cost that may arise
due to the inability to claim a credit for foreign taxes paid
for PRC tax purposes on profit repatriations. Alternatively, a
restructure of the overseas target group to "flatten" the
number of tiers of foreign subsidiaries may be required, which
might trigger upfront tax and non-tax costs for the
investor.

Controlled foreign companies

Article 45 of the PRC Corporate Income Tax law is the PRC's
controlled foreign company regime. Where an offshore entity is
considered a controlled foreign company under article 45, the
PRC resident shareholder will be required to include an amount
equal to its effective interest in the foreign enterprises'
undistributed profits as a deemed dividend when computing their
own PRC taxable income. In other words, the profits derived by
its foreign subsidiaries which are kept outside of the PRC will
still be taxable in the PRC notwithstanding that they have not
yet been repatriated.

Broadly, article 45 will apply if a foreign entity is
controlled by PRC tax residents; if the effective foreign tax
burden on the profits of the foreign entity is less than half
of the PRC corporate tax rate (i.e., less than 12.5%); and if
the foreign entity fails to distribute its profits without a
legitimate commercial reason or reasonable operational
need.

Managing the application of article 45 to foreign subsidiary
entities is crucial to managing PRC tax payments and overall
cash flow concerns, particularly where the offshore operations
are structured through entities located in jurisdictions which
effectively tax the profits at a rate lower than the PRC.
Typically, PRC entities with subsidiaries in such jurisdictions
would need to demonstrate legitimate commercial reasons or some
reasonable operational need for retaining funds and not
distributing profits back to the PRC, for example, reinvestment
of the funds into underlying business or business
expansion.

China issued, in draft form, certain revisions to its
controlled foreign companies (CFC) rules in 2015, which would
see some tightening around the determination of 'control' for
CFC purposes. It also proposed the removal or amendments to
certain exclusions provisions from the application of the CFC
rules. The Chinese authorities have not yet finalised these new
rules, but these are anticipated to be issued sometime in
2017.

We have seen the Chinese authorities invoke the CFC rules on
a limited number of enforcement cases in the last few years.
However, we expect this issue will become more closely
scruitinised once revised rules are finalised and
published.

New tax reporting obligations

In addition to managing the overseas and PRC tax costs on
its overseas investments, Chinese investors should take notice
of new tax reporting obligations, which could potentially cover
their overseas investments. Last year, the State Administration
of Taxation issued an announcement that updated China's
transfer pricing documentation requirements and introduced new
country-by-country reporting (CbCR) requirements for Chinese
groups and their consolidated subsidiaries (Announcement 42:
The Enhancement of the Reporting of Related Party Transactions
and Administration of Contemporaneous Documentation).

The new Chinese CbCR obligations will be triggered where the
Chinese investor is the ultimate holding company for a
multinational group, which has a consolidated revenue of CNY
5.5 billion ($800 million) in its previous fiscal year exceeds,
roughly equal to the €750 million threshold under BEPS
Action 13. The new CbCR requirements will apply from the 2016
fiscal year onwards and the CBC report will need to be
submitted annually together with the Chinese investor's income
tax return (due in May of the following year). As such, Chinese
investors who have completed or are considering making overseas
investments that will result in the group exceeding the CBC
reporting threshold should take appropriate steps to compile
and report the required data.

Closing remarks

Managing PRC tax issues can be just as important as foreign
tax considerations when implementing an effective holding
structure for overseas investment. Chinese investors should be
careful in observing the relevant PRC tax rules to ensure that
their offshore structures are effective and can therefore
achieve their intended result of maximising the after-tax
returns from such investments.

John Gu

John Gu is a partner and head of deal advisory,
M&A tax and head of private equity for KPMG China.
He is based in Beijing and leads the national tax
practice serving private equity clients. John focuses
on regulatory and tax structuring of inbound M&A
transactions and foreign direct investments in the
People's Republic of China (PRC). He has assisted many
offshore funds and Renminibi (RMB) fund formations in
the PRC and has advised on tax issues concerning a wide
range of inbound M&A transactions in the PRC in the
areas of real estate, infrastructure, sales and
distribution, manufacturing, and financial
services.

Michael Wong

Michael Wong is a partner and head of the outbound
tax practice for KPMG China. He is based in Beijing and
leads the national outbound tax practice serving state
owned and privately owned PRC companies in relation to
their outbound investments. Michael has extensive
experience leading global teams to assist Chinese
state-owned and privately-owned companies conduct
large-scale overseas M&A transactions in various
sectors including energy and power, mining, financial
services, manufacturing, infrastructure and real
estate.

Alan O'Connor

Alan O'Connor joined KPMG Hong Kong from Australia
in 2000 and became a director in 2013. He worked in
Hong Kong for more than 10 years before relocating to
Beijing in 2011, where he continues to provide tax
services to Chinese outbound investors. He has
extensive experience providing due diligence and
transaction related tax advisory services to major Hong
Kong and Chinese based clients, and has been involved
in international tax planning projects, merger and
acquisition transactions and due diligence exercises
involving Asia, Europe and North America.

Karen Lin

Karen joined KPMG Hong Kong in 2005 and KPMG Beijing
in 2011. Since 2011, Karen has been specializing in
international taxation and assisting Chinese
multinational corporations with outbound M&A
transactions, including international tax structuring,
tax due diligence and transaction related tax advisory
services. During 2014 and 2015, Karen joined a NASDAQ
listed multi national media group focusing in managing
the group's taxation matters covering the Asia Pacific
region.